The Monetary Base: Context Matters

In 2008, the monetary base started increasing dramatically. Today, there are two major views on monetary policy that view this increase as supporting evidence. The first view, typically advocated by hawkish, right-wing monetarist-types is that the dramatic increase in the monetary base suggests that the United States is headed for high inflation. The second view, typically advocated by left-wing, Keynesian types, is that the United States is currently in a liquidity trap. The first group sees the substantial increase in the monetary policy as a predictor of inflation on quantity-theoretic grounds. The second group thinks that the fact that the base has increased so substantially without promoting recovery provides support for the hypothesis of a liquidity trap, whereby monetary policy is impotent.

I would like to suggest a third view.

A consistent concept throughout monetary theory is that of monetary disequilibrium. Central to monetary disequilibrium theory is the understanding that money is the medium of exchange. Since this means that money is traded in all markets, it follows from Walras’ Law that when there is an excess supply of money, excess demand will exist in all other markets. Similarly, this means that if there is an excess demand for money, an excess supply will exist in all other markets. Since money trades in all markets, the price level must adjust. If prices do not adjust instantaneously, this will also result in changes in production.

A simple way of looking at this theory is through the equation of exchange:

MV = PY

where M is money, V is velocity, P is the price level, and Y is output. For simplicity, M will be defined as the monetary base. Velocity reflects changes in the demand for the monetary base.

An excess supply of money occurs when the monetary base increases or the demand for the monetary base declines (V increases), ceteris paribus. An excess demand for money occurs when the monetary base decreases or the demand for the monetary base increases (V falls), ceteris paribus. It follows from the equation of exchange that an excess supply of money leads to an increase in nominal income (PY) and an excess demand for money leads to a decline in nominal income.

The first view articulated above sees the expansion in the monetary base as reflecting an excess supply of money and therefore anticipates higher inflation. The poor performance of nominal income over the last two years would seem to call into question this view. However, advocates typically point out that there are long and variable lags associated with monetary change or that current increases in money demand won’t last forever and when they subside, inflation will emerge.

The second view sees the combination of the expansion of the monetary base and the poor performance of nominal income as evidence of a liquidity trap. Under this view increases in the supply of money are offset by increasing in the demand for money and have no influence on the economy.

I believe that both of these views are wrong. A careful discussion of how monetary policy works will elucidate my point.

Monetary policy is typically conducted through open market operations, in which the central bank buys and sells short-term government bonds. The central bank credits or debits a bank’s reserve account depending on the transaction. Suppose that the central bank conducts an open market purchase. In this scenario, bank reserves increase and therefore the monetary base increases.

In the typical monetarist-type view, the exchange of money for bonds generates a disequilibrium in the bank’s portfolio. The bank will then seek to re-align their portfolio through a series of asset substitutions. This results, initially, in changes in output and, ultimately, prices.

In the Keynesian view, when interest rates are zero, money and bonds become perfect substitutes. As a result, an open market purchase just leads to a reduction in velocity and no change in output or prices.

The problem with using either of these methods to evaluate monetary policy in the present context is because the Federal Reserve is not issuing new base money. The Fed has been issuing debt.

In October 2008, the Federal Reserve started paying interest on reserves and therefore effectively issuing debt. As a result, open market operations have not entailed exchanging base money with government debt, but rather Federal Reserve debt with government debt. Given that the yield on a 90-day T-bill is roughly equivalent to the interest payments on excess reserves, the Federal Reserve is literally exchanging perfect substitutes, but it has nothing to do with a liquidity trap. Thus, the effective monetary base is not changing all that much despite the evidence from the graph above.

11 responses to “The Monetary Base: Context Matters”

The Fed did not expand the monetary base in order to buy perfect substitutes. In October 2008 the base was expanded in order to expand various credit easing facilities. The lesson is that even more dramatic increase in monetary base was needed to restore the monetary equilibrium. Why such dramatic increase was required? Because markets were expecting a dramatic contraction of broad monetary aggregates.

IOR or no IOR, with such expanded monetary base the yield on a 90-day T-bills will always be equal to the yield on reserves. Yield on 90-day T-bills will fall to zero if IOR is abolished, unless Fed’s balance sheet contracts sharply.

“IOR or no IOR, with such expanded monetary base the yield on a 90-day T-bills will always be equal to the yield on reserves. Yield on 90-day T-bills will fall to zero if IOR is abolished, unless Fed’s balance sheet contracts sharply.”

More or less. I am setting the stage for talking about quantitative easing and the differences between buying short-term bonds, long-term bonds, and other assets.

The other possibility is that the Fed is like a firm that issues new shares of stock. As the new shares are issued, the firm’s assets rise in step with its liabilities, so the firm is normally in a position to buy back the newly-issued shares at par, and the shares therefore hold their value even though there are more shares.

As the Fed issued more money, it got more assets at the same time, and that’s why the dollar has held its value.

Can you please help me understand the significance of this concept of “imperfect substitutes.”? My understanding is that for monetary stimulus to work, the newly created cash, and whatever purchased assets by the fed, have to be imperfect substitutes for each other. Now that interest rates are zero, cash and bonds are nearly perfect substitutes, and thus the hot potato process never gets going.

I cannot find an explanation anywhere on this idea. Why must they be imperfect substitutes for the hot potato process to begin? I have been reading the blogs on this for one to two years, but this is never explained in full, and no macro textbooks explain these ideas.

Moreover, why is the definition of the liquidity trap as “cash and short-term bonds are perfect substitutes” the same as defining it as “money demand is perfectly elastic?

“I never said this was the purpose, but rather what they are effectively doing.”
So far the Fed has successfully avoided doing useless OMOs, although there is some risk that QE2 will consist of useless OMOs.

“More or less. I am setting the stage for talking about quantitative easing and the differences between buying short-term bonds, long-term bonds, and other assets.”
It should be possible to set the stage without using the IOR bogeyman.

The Fed started paying interest on reserves just when greater monetary expansion was needed. Unless the Fed would have contracted the monetary base to offset the absence of interest on reserves, the consequence can only be contractionary. The Fed’s desire to regain control over the federal funds rate by paying interest on reserves seems due to a unhealthy obsession with its favourite policy “tool”. While I have no objection to paying interest on reserves in principle, 2008 was not the year to begin doing so (not unless the rate was negative).

Because of the excess reserves in the system the funds rate would go to zero everyday if not for IOER. IOER creates a floor under the funds rate. So 2008 was precisely the year to set up the facility because that is when the FED created the excess reserves by growing their balance sheet.

I just don’t think the fed funds rate is important. What the Fed needs to concern itself with is stabilising nominal income expectations on some future growth path, though the same for inflation would be an improvement at the moment. The fed funds rate should just be allowed to go where it needs to go to clear its market. While movements in the fed funds rate may correlate with easy or tight money in particular conditions, there is no mechanical relation. Indeed, easy money is likely to increase the fed funds rate in the present economic environment.

I just don’t get the obsession with the fed funds rate. The Fed directly controls the supply of base money and indirectly alters the supply of broader money supplies. It also may control expectations of future nominal aggregates like inflation and nominal income. Those should be its “tools”, not the fed funds rate.

Operationally the FED would rather the funds rate not go to zero every day and drag short term money markets with it. That is all IOER does. You may not be one of them, but so many people are obsessed with IOER. It creates the floor on the funds rate just like the discount rate tends to create a ceiling. I doubt it is having any kind of macro impact right now other than keep the funds rate 22bps higher.